Toro And The Runaway Recovery

By Stephen D. Simpson, CFA | December 07, 2012 AAA

Wall Street is always looking for a rebound play, and there has been no shortage of interest in going long on the housing/consumer recovery this year. While data from home improvement superstores like Home Depot (NYSE:HD) and Lowe's (NYSE:LOW) does indeed support the idea that the worst has passed, investors have been pretty aggressive in bidding up many residential housing plays. Toro (NYSE:TTC) remains a top-notch manufacturing company, but absent a buyout bid, it seems hard to see how cash flow is going to grow fast enough to leave much upside on the table for today's buyers.

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A Tough End to the Fiscal Year
While Toro saw decent activity in the professional business (largely with good performance in golf), a very disappointing retail inventory build for snow removal equipment pretty much gutted profitability. Worse still, management's downward revision in guidance suggests that perhaps investors have gotten a bit ahead of themselves on the recovery trade.

Revenue fell 8% for the fiscal fourth quarter, as the company saw almost a 6% growth in the professional business offset by a 29% decline in the residential business. Sales in residential were crushed by weak orders for snow removal equipment (retailers like Home Depot order months ahead of expected sales), as many retailers got burned by last year's very mild winter.

With a lower sales base, Toro struggled to leverage its fixed costs. Gross margin did improve a 60 basis points (BPS) from last year, but operating income plunged by 55% and interest payments basically wiped out all of the company's profit for the quarter. Within the operating lines, earnings in the professional segment were up 21%, while residential segment profits dropped 43% on some rather severe de-leveraging.

SEE: How To Decode A Company's Earnings Report

Expectations Meet Reality, and Reality Wins
Investors don't have to look hard to find examples of outperformers whose performance can be tied to the nascent residential housing recovery. Floor covering maker Mohawk (NYSE:MHK) is up nearly 50% over the past year, Masco (NYSE:MAS) is up 72% and the aforementioned Home Depot is up about 60%. With Toro's stock up 50% over the past year (against a 4% rise in revenue and 11% increase in operating profits), it's pretty clear that investors are now expecting a good rebound in businesses tied to residential and consumer spending.

To be sure, this is legitimate to a point. For Toro ((as well as companies like Deere (NYSE:DE), Kubota (NYSE:KUB) and Honda Motor (NYSE:HMC)), a good recovery in the golf industry (rounds played up by a low teens percentage) has certainly helped orders and expectations for 2013. Likewise, homeowners are spending again to fix up or maintain their homes and there is likely to be pent-up demand fueling above-trend revenue growth for at least a few years.

But there's a big difference between "better" and "everything's fine again." Retail sell-through has improved, but is still a good distance from the pre-housing crunch level. Likewise, stagnant wage growth, persistent unemployment, weak consumer confidence and risks tied to the fiscal cliff are all weighing on consumer demand. To that end, Toro management trimmed revenue growth expectations by about 1% relative to analyst assumptions and pointed to an ongoing sub-optimal level of incremental profitability.

SEE: 5 Factors To Watch In A Housing Recovery

The Bottom Line
Toro is a fine company. Actually, Toro is better than fine, as management has succeeded in leveraging strong brands like Toro and Lawn-Boy into relatively consistent double-digit returns on capital that often goes into the 20% range. If anything, it's a bit surprising that Toro is still public as it could fit neatly into a number of conglomerates.

While Toro's quality is up there, the value is not. Even if Toro can log more revenue growth in the coming decade than in the past and lift its average free cash flow margin by more than a point, the resulting high single digit free cash flow growth only supports a fair value in the low to mid $40s. That makes Toro a very interesting name to reconsider on a pullback, but not especially compelling today.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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